Houston-based DKRW Advanced Fuels has a dream: they want to turn a chunk of Wyoming's vast coal reserves into 10,600 barrels of gasoline per day. They want to capture most of the carbon emitted in the process and sell it to the state's oil and gas industry, which will use the CO2 to inject into wells, increasing oil and gas production. In one fell swoop, the firm hopes to boost production of all of the state's major fossil fuels. The facility would be located near Medicine Bow, a town that presently has about 300 people.

Dreaming with somebody else's money

Oh, and part of the dream that they don't broadcast quite so loudly is that they want to do it mostly with our money. The firm has an application in with DOE for a $1.7 billion loan guarantee, which passed DOE preliminary review in 2009. And they've recently gotten approval from the Carbon County Commission to issue $245 million in tax exempt bonds. This debt is guaranteed by the project not by the County, but subsidized by taxpayers because the interest is free from taxation. It will also use up most of the state's annual alotment to issue tax exempt, non-municipal bonds.

There's more at the subsidy salad-bar: the Commission also unanimously endorsed issuing $300 million in industrial development bonds, which DKRW has asked the state's Permanent Mineral Trust Fund to purchase. From time-to-time, the Trust Fund does invest in Wyoming-based enterprises, and DKRW has indicated that they think their plant should be one of them.

The venture is also being supported by $10 million in state funding to support pre-construction studies both for the DKRW facility, and another project under consideration within WY that would convert natural gas into vehicle fuels.

Bob Kelly, executive chairman of DRKW, is happy so far with the state's involvement. As noted in a recent story in the Casper Star-Tribune, Kelly

said the bonds are "very helpful" in assembling the $1.7 billion to $2 billion needed to finance the plant's construction. Kelly said the company is seeking bank financing to cover the rest of the plant's cost [emphasis added].

Where's the equity?

Billions at risk, leveraged from other people. This should always be a flag that extreme due diligence is needed. The fact that the entire top management team at DKRW Advanced fuels (Robert Kelly, Jon Doyle, William Gathman, Jude Rolfe, Robert Moss, and Wade Cline) are out of Enron does nothing to ameliorate the concern.

Kelly's statement also begs the question "where's the equity"? DOE's guarantees require a minimum of 20% equity investment. It's not from DOE. It's not in the tax-exempt bonds, and it's not in the "bank financing to cover the rest of the plant's cost." That, perhaps, leaves the $300m that DKRW is trying to get the state of Wyoming to plow in. That funding seems to be structured like debt, because there is no mention of the state getting a stake in the company for the money. It is clearly like risk capital in terms of the investment it is supporting, however. Nonetheless, the limited equity requirement under the DOE program was focused on aligning the incentives of managers with the venture's success by requiring them to have "skin in the game." Government money wouldn't seem to cut it.

To it's credit, Wyoming is approaching the investment with some caution. The Treasurer's Office has requested input on deal soundness from the Wyoming Business Council, which in turn has asked for a technical review from Idaho National Laboratory. Mike Martin, at the Business Council, did not think the INL review went beyond technical issues to include as well a review of the financial suitability of the project for the state's Mineral Trust Fund. He was also not clear whether the INL review would examine systemic risk factors, such as what would happen to plant economics should a price or cap on carbon emissions be instituted. INL's review should look at both of these items, as federal and Wyoming taxpayers will have lots at risk if this plant moves forward with so much public subsidy.

A second check to the spending comes from the legislature. An investment of $300m would require Legislative approval, making it more difficult to put state funds at risk foolishly. However, investments up to $100 million would not, and State Senator Phil Nicholas, chairman of the Senate Appropriations Committee, has said the leadership would be comfortable with buying $50 to $100 million of the bonds. As evident from the table below, even at these lower levels, the funding would materially alter the Trust Fund's asset allocations and DKRW would comprise one of its largest, non-diversified investments.

DKRW investment conflicts with the purpose of the Permanent Mineral Trust Fund

To look at the issue of financial suitability, I pulled existing data on the state's Permanent Mineral Trust Fund (summarized in the table below). The purpose of this fund, and many others like it around the world, is simple: mandate a portion of mineral revenues to go into an investment fund for the benefit of future residents of the resource-producing region -- be it a county, a state, or an entire country. This solves two problems at once. First, the mandate removes from political control at least part of the massive cash flow that comes from resource booms. Without such a mandate, the potential benefits of resource booms were often lost as politicians squandered the surge in funds on foolish projects, empire building, or corruption. Second, the Trust Fund approach requires an independent fund manager to invest in a widely diversified set of assets. The income and growth of these other assets reduce the correlation between energy or mineral prices and the available revenues to the state, helping to dampen the boom-bust resource cycles as well.

Based on the criteria for which the Mineral Trust Fund was established, investing in DKRW should be immediately rejected, even at funding levels well below the requested $300m. Regardless of whether INL decides the plant is technically sound, the investment further concentrates Wyoming's financial exposure to energy prices rather than diversifying away from them, and therefore works counter to the intent of the Mineral Trust Fund.

Further, as shown below, the scale of investment is far more concentrated that what currently exists in the Fund's portfolio. At first blush, a $300m investment in the plant may not seem like a big deal, comprising well less than 10% of more than $5 billion in total holdings of the Trust Fund. Yet, for any of the conceivable asset classes in which the investment could fit, exposure to DKRW would dominate the class, comprising at least than 2/3 of the resultant asset class sizing (current size plus DKRW holding) in every case. This metric actually understates the risk since the existing portfolio has many small investments, rather than large lumpy ones like the proposed holding in DKRW.

I looked at four potential asset categories in which DKRW could possibly fit. Because the investment would be debt with no equity interest, I considered corporate bonds. However, the risk of this venture is far higher than what a normal corporate bond portfolio would entail; and if I were the Treasurer, I would require equity interests as well. If we assume the state were to get an equity interest as well, conceivably small- to mid-sized (SMID) US equity would be an asset-class fit. But again, the risk is higher than what a SMID portfolio would normally entail due to the high technology risks of the plant, and the investment would have some elements of debt rather than being pure equity. Private equity is probably the best match in terms of risk level -- though one that would require much higher returns to the state than what is likely being considered at present.

The final category considered was intra-Wyoming investments. Like the other possible categories, DKRW would come to dominate the WY holdings at a $300m sizing. Not only would be the size of the investment be larger than what currently exists within the intra-WY holdings, but many of the existing investments benefit multiple firms or people, not a single project. Many of these projects also have a clear public interest component (beyond simple job creation), something that DKRW investment does not.

For additional reading on the planned DKRW coal-to-gasoline plant in Medicine Bow, Wyoming Public Radio just did an interesting series of reports. Taxpayers for Common Sense also has a good backgrounder. Update, 2/16: An interesting op-ed in the Casper Tribune by Jason Lillegraven goes into some detail on problems with the environmental assessments done on the project to date, particularly with regards to water consumption. For so many of these facilities, water is the achilles heel. Too often, the facilities pay little or nothing for the amount of water they use. Just as running a sensitivity on project returns assuming CO2 emissions won't always be free, it would be prudent to do the same with water.

Wyoming Ownership of DKRW bonds

I. DKRW wants fund set up to diversify away from minerals to invest in CTL

Fund that would own the bonds

WY Permanent Mineral Trust Fund

State investment requested by DKRW

$300,000,000

Total Fund holdings, 6/30/11

$5,050,000,000

II. Concentrated DKRW investment would dominate any asset class it is attributed to

Possible asset class categories for DKRW investment

Asset class holdings as of 6/30/11

DKRW investment/ existing asset class sizing

Corporate bonds

$189,100,000

159%

Small/mid cap US equities

$186,200,000

161%

Private equity

$129,500,000

232%

Wyoming investments

$121,300,000

247%

III. Scale of DKRW investment would be much larger than other intra-WY investments